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More tidbits about Risk-Reward ratio

ThoughttheRisk-Reward or the Reward To Risk ratio is another important aspects of trading,it is more often than notcompletely misunderstoodand might even be misleading for market participants.

So to clear the water a bitin this article we try toshow the reason of it.

Different people use and interpret the Risk-Rewarddifferently.

1.

The quantitative analystand portfolio manager uses statistical models andknowwhat is related to the Risk-Reward ratio and uses the correct mathematical mechanism tomake the estimates. Since it isrelated to standard deviationin a specific distributionthe professional canseethecorrectratio and make the properaction and decision based on that.

2.

Thebroker, who sells a selection ofassetsor suggestbuyingopportunities, oftenrelates to GoodRisk-Reward characteristics or simply good risk reward, to enticepotential buyers, withoutreally knowing the details. It is becauseit is not in his deepest interest to know the details, or it would be a lot of workto really know the details.

3.

The trader, especially the intuitive trader usually do not have time to go deepinto statistical analysis to find outthe true, objective risk / reward characteristics of a given situation.

Here lies the biggest danger. This is one important reasonmanytraderssimplylose money, eventhough he / she might play only good Risk-Reward situations / setupsin histrading practice.

Whyis this?

To make it obvious, I cut and paste the explanation of the Risk-Reward ratio frominvestopedia.com:

“Investopedia explains Risk/Reward RatioLet's say a trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that her losses will not exceed $500. Let's also assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing her position. Since the trader stands to make double the amount that she has risked, she would be said to have a 2:1 risk/reward ratio on that particular trade. The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy.”

I highlighted the trick in this whole exercise.The real problem is that the trader believes something, that actually has nothing to do with reality. Ultimately thisfalse belief without real knowledge might lead tobig consistent losses.

Hey, I can suggest you the best Risk-Reward of a lifetimeevery week!

Just buy a lottery ticket for Five dollars, andplay for the 5 million dollarprize every week.Would you play thisone to a million Risk-Rewardinstead of the 1 to two, one to three? If you are really smart, thanyou would probably not play thatevery week, unless you are really poor and desperate to grab the only (close to zero)probability togeta real life.

Getting the point?

To demonstrate the situation with another example,I created thefollowing Chart, thatcould be used during trading:

The Reward to Riskratio (Assuming that you place your Stop level just below the Low price and profit targetat the midpoint of the Low – High range.) would beabout fiveto one, based on this chart.

Would you buy this setup at this point?

We go on and describe further the situation.

Imaginethe following two scenarios:

1.The chart aboveis the 10 Year chart of a big multinationaltechnology company, whichisalready extremely entrenchedin all world markets andsaw its stock price erode during the pastthree years due toincreasing competitions anddue to the fact, that its products got commoditized.

Though the stock price got some lift recently due to general market condition improvement, butthe company does not havea bright future profit – growth potential, exceptstaying in the market and paying divided.

2.The other situation is that the above chart depicts the

intraday five minute chart ofa big stable high tech

company.

During this daily session we already saw the pricethree percent above current levels,and now the stockis gaining momentum again,obviouslyregarding valuations there are a lot ofmarket players, who consider the fair value of this stock a bargain at this price.

We know that stock chartsare so-called scale independent charts, so withoutactual time-periods the time-frame of a given chart could beanything, the chart could still be a real,validhistorical chart.

But we intentionallyleft out the time–frame to

demonstrate the Reward to Riskwith this example.

Would You buythis chart setup atthis point?

The answer obviously could be:

- Yes, I would buy the first situation.

- Yes, I would buy only the second situation.

- Yes, I would buy both situations.

- No I would Not buy any of these situations.

What is Your reason, behind your decision?

At least for us the reasoning is dictated by the statistics.

And what did it say above?Nothing.

For this reason we would not buy any of these situations.

Weknow nothing about potential rewards and especially nothing about the probability, that the price will hit themid–price of the chart.

The main reason, that the Reward to Risk ratio is misleadingor mostly damaging for manymarket players is that they do not have statistics, probability numbers about reaching their profit targets.

It is completely worthless withoutthose win probability numbers.

For this reason we would highly suggest to use something elseinstead oftheReward to Risk ratio in situations, when we have no availableprobability, and even if we have it,we might prefer to useexpected profit calculations or profit factor calculations.

Since the onlysurely controlledamount is the Risk (Assuming that we entered aSTOP order into the brokerage account.)it would be better to use theRisk / Total trading capitalto play the markets, andrisk only a predefined maximum of 1 – 5% of our capital, depending on which time-framewe are playing.

And one finaldescription of the chart with someother knowledge about markets:

Assume, that the chart isthe intraday5 minutes chart of a high tech multinational, whichis a true market leader.

The marketin a strong multi-week uptrend,and themarket, and along with it this stockpulled backin these situations for the third day in a row.

The stock has a 0.85correlation with the market index, and the market internals are definitely improving, huge buyers showed up on the market pushing up most of the sectors during the day in the last 30 minutes.

During these situations, the marketmoved up78% of the time after a two days pullback in the strong uptrend and reversed the direction.

Would you buythe stockat the market “Buy point” having allthesedata available?

I would say Yes,also knowing the undefined“Market internal improvement”means, that the marketdid not change direction for the next 30 minutes 85% of the cases. Not buying foranother 3 hours, but buying for at least 30 minutes.